Balkrishna Industries - Big bets and big promises

At the turn of the new millennium, Yogesh Mahansaria, a bright-eyed 25-year-old
was asked to take control of a small tyre manufacturer in Aurangabad. He had
been working there for a few years with his father and was seen as someone who
could turn around the company's fortunes and when his chance came, he did it
with style. And then in 2006 when it seemed like the humble tyre company was
just about to take off, he was abruptly asked to leave. By all measure, this was
an unceremonious exit for a man who had virtually transformed the company from
being a loss making entity to a $120 million global brand. But the controversial
move nonetheless ushered in a new era and it's now on a quest to reach a billion
dollars in annual turnover. Our story today is about Balkrishna Industries, a
company that makes Off-Highway tyres (OHT) used in Agriculture and Mining
equipment and whose stock has gained cult status within the investor community.
But before we get to the meat of the story and the inherent investment
opportunity we need to take a small detour and go back in time.

The Malthusian Prophecy

When Robert Malthus propounded one of the most controversial ideas of the 18th
century there was considerable fear about humanity's ability to survive in the
face of rising population. His principal contention was that while food
production would grow linearly, population growth would be exponential. This, he
believed would lead us to a point where world population would far outstrip food
production rates and create a widespread scarcity of grain and foodstuff.
Malthus was of the opinion that such a crisis could be averted only if natural
forces intervened to fix the imbalance between food supply and population growth
through natural disasters such as floods and earthquakes. Luckily for us,
Malthus turned out to be wrong. As history would have it, people did not die of
starvation, instead, the industrial revolution paved the way for farm
mechanisation which in turn drastically improved farm productivity. And almost
two centuries later this idea forms the cornerstone of the investment thesis
most people ascribe to Balkrishna Industries.

The Connection

Whilst dealing with an investment opportunity, any decision on future outcome
relies heavily on an investor's ability to weave a compelling narrative about
the stock. Considering Balkrishna tended to Agricultural producers (65% of the
revenue comes from the agricultural tyre segment), the story that most people
put together focused on farm automation i.e. "As farmland decreases and
population grows, more farmers will resort to improving productivity by moving
away from manual labour to semi/fully automated farm equipment." This, they
believed would create a booming market for Off-Highway tyres and provide
considerable demand visibility for the company. However, this view
oversimplifies the complexities inherent in assessing future demand and it
offers an incomplete assessment of the current scenario.

Farm mechanisation does not happen overnight and is often overshadowed by more
immediate concerns. Take for example how farmers react to declining food prices.
In an uncertain price environment farmers often delay their purchase decision
until they can be fairly certain about their return on investment. So, if food
prices are on a decline, it's unlikely you will see a boom in the agricultural
OHT segment. According to the Food and Agricultural Organisation of the United
States, the food price index has been on a steady decline for quite some time
now. From 229 points in the year 2011 to 168 points last year, the index has
seen a drop of nearly 26% over 7 years. So despite the mechanisation narrative,
short term trends have been unfavourable towards farmers and agriculture in
general.

Point of Interest : Titan International Inc., the largest producer of
specialty tyres in the United States had this to say about the matter in 2018 —
Rising interest rates and sluggish commodity prices also threaten farmer demand
for new equipment through the remainder of this year and
beyond. These uncertainties create the potential for farmers to further
delay upgrading their equipment

It's also ironic that most of the untapped opportunity for farm mechanisation
rests in Asia whilst Balkrishna Industries continues to generate a bulk of its
revenue from exports to Europe and the U.S. The mechanisation narrative would
make sense if investors were to witness an increase in domestic sales or exports
to other Asian countries. However, that hasn't happened and even if it did, it's
unlikely that a retail investor will notice the marginal impact of this trend on
yearly sales volume.

Another contention is that Balkrishna's growth was driven by the mining sector.
Mining companies that operate large vehicles need heavy-duty off-road tyres and
the sector contributes to about 13% of the company's total sales volume. So if
there ever was a burgeoning demand for Off-Highway tyres somewhere, it must have
been lurking in the underbelly of the mining industry. However, the mining
companies have been fighting their own demons for quite some time now. As one
industry report from 2016 succinctly quotes — "The golden age of mining —
underpinned by the rise of emerging markets which require large quantities of
metal — is now a distant memory… The slump in raw material prices.. aggravated
by the oil counter-shock of 2014 [has] suffocated the mining sector supercycle."
Since 2012, very few mining companies have engaged in large scale greenfield
expansion and its only in the past two years that we have seen some recovery in
the mining sector. So contrary to popular belief, Balkrishna Industries was
operating in an unfavourable business environment that should have crippled the
stock and yet seemingly defying all odds they've grown both in size and
stature. How do you explain such a contradiction?

The Competition

In an Op-ed piece describing the effects of Globalisation, Thomas Freidman, a
Pulitzer Prize-winning journalist made a prescient remark back in 2005. He wrote
— "French voters are trying to preserve a 35-hour work week in a world where
Indian engineers are ready to work a 35-hour day ... Next to India, Western
Europe looks like an assisted-living facility with Turkish nurses… The dirty
little secret is that India is taking work from Europe or America not simply
because of low wages. It is also because Indians are ready to work harder and
can do anything from answering your phone to designing your next airplane or
car. They are not racing us to the bottom. They are racing us to the top."

When Balkrishna Industries started manufacturing Off-Highway tires, they had
two distinct advantages — access to cheap labour and a growing talent pool.
Their competition meanwhile was dealing with cost overruns and an expensive
workforce. So when the company started selling tyres at a significant discount
to most available alternatives they found a niche market that they could tend
to. In fact, the depressing business environment aided Balkrishna's cause as
opposed to stifling its growth. As food prices began to decline, farmers
scouting for economical replacement tyres found considerable value in the
company's product offering. Whilst there isn't any direct proof to substantiate
this claim there is some anecdotal evidence to suggest that distressed farmers
were indeed looking for cheaper alternatives.

When the former CEO of the American Tyre maker, Titan International, shunted an
offer to buy-out an ailing tyre plant in France he offered an unusually honest
assessment of the entire scenario. "The French farmer wants cheap tire. He
does not care if the tires are from China or India …. Titan is going to buy a
Chinese tire company or an Indian one, pay less than one Euro per hour and ship
all the tires France needs. You can keep the so-called workers. Titan has no
interest in the Amien North factory." In fact, unlike most companies that
grew on the back of increasing demand, it seems Balkrishna, like other Indian
tyre manufacturers, grew largely at the expense of their competitor's inability
to cut costs.

Back in 2004, the giants of the tyre manufacturing industry — Bridgestone,
Michelin and Continental, dominated the competition catering to over 50% of the
market. However, with the introduction of Asian manufacturers, they slowly began
to cede market share and are currently down close to 30%. Balkrishna
Industries, on the other hand, continues to grow. From 3% in 2011 to 5% in 2018,
they've consistently managed to add to their total market share by following a
cost-effective model. This addition in market share was complemented by a benign
price environment for natural rubber (the principal raw material used in the
production of tyres) over the past two years which augured well for both profits
and the stock price. Another important feature of Balkrishna's growth story is
that the Chinese have largely stayed away from the market.

Unlike other sectors, the OHT segment is a large SKU low volume business i.e. a
business where the end consumers seek multiple varieties of tyres in low
quantities and the Chinese don't tread areas where mass production becomes
unviable.

Point of Interest : We intentionally used the words "largely stayed away" to
explain Chinese disinterest in the OHT segment because while they haven't had
any significant market share in this specialty sector, they did in fact start
dumping cheap tyres everywhere back in 2016. This move had a visible impact on
the top line of most tyre manufacturers, including Balkrishna

And that brings us to today. Although there is little Chinese competition now,
the landscape is considerably different than it once was. When in 2011, there
was only one large low-cost OHT manufacturer in the world, now there's two.
Welcome to the second coming of Yogesh Mahansaria.

The Redemption

After his resignation from the board, Mahansaria went on to birth another
Off-Highway Tire manufacturing facility — The Alliance Tyre Company (ATG). With
the backing of a private equity firm he first bought out an ailing plant in
Israel outbidding competition and seemingly snatching it from the clutches of
the U.S giant Titan International. He then set up two plants in India to reap
potential cost-saving benefits and bought out another plant in the U.S to avail
opportunities in the American markets. Within 10 years he had built a company
that could match Balkrishna in size and it seemed as if the company's promoters
— The Poddar family had a new nemesis in town. Unfortunately for us, the drama
ceased abruptly in 2016, when Yokohama tyres bought out ATG for a whopping $1.2
Billion. For the uninitiated, Yokohama is one of Asia's largest tyre
manufacturing company and their new subsidiary (ATG) is on an aggressive
expansion campaign deploying the same strategy that helped Balkrishna
Industries thrive.

While lax competition initially provided the perfect launchpad for Balkrishna's
growth story, new competition looms on the horizon with deep pockets in tow. It
seems the chips are finally down and the company has been forced to play its
hand. It has initiated new plans to expand capacity including a plant to
manufacture carbon black, a key raw material used to manufacture tyres. It has
also initiated plans to set up a manufacturing plant in the U.S. When news of
this development broke, the stock price tumbled precipitously and for good
reason. Labour in the U.S is about 10 times more expensive than India and the
uncertainty involved in adding new capacity in foreign soil can erode investor
confidence pretty quickly. On a more positive note, the last time the company
undertook capacity expansion it did it with considerable panache. But with
intense competition looming large very little is certain.

Usually, in our story, it would be at this point we would tell you that the
future of Balkrishna Tyres hangs very much in the balance and offer you our
best wishes if you were to invest in the stock. However, there is something else
we must address before we wrap this one.

Why we don't give out Buy/Sell Calls

If there's one criticism that we often receive, it's that we never offer a
target price — that we lack conviction in our analysis and that we never take a
clear stand. Consider for a moment the method of forecasting. Imagine you had to
put a number on Balkrishna's stock price, you'd first have to consider the
political climate and the macroeconomic variables surrounding agriculture and
mining. You would then have to plug in the savings impact of the Carbon Black
plant, competitive threats from ATG, potential cost overruns in adding new
capacity, profitability of the new plant in the U.S, future opportunities
accruing out of new unexplored territories, threats of anti-dumping duties and
its immediate impact on cash flows, cost of debt and other black swan events.
Once you are done with that pesky little bit, you'd have to assess the current
mood of the market i.e. decide if the market is paying more/less than the
intrinsic value of the stock (In 2011, the stock was trading at a P/E multiple
of 9. It's currently trading at about ~20). Depending on how long you are
looking to hold the stock, you might have to assess the future mood of the
market as well. Finally, you toss out all the calculations you've so
painstakingly constructed, listen to your gut and put out a number that's
closest to market consensus (or if you're looking to stand out, throw a number
that's furthest away from the consensus) It's no wonder then that Burton Malkiel
famously remarked — "Financial projection appears to be a science that makes
astrology look respectable"

The fact of the matter is even if we did offer you a target price, it would at
best be a well-meaning guess and not much more. It would only perpetuate a
pernicious illusion that the future is more "knowable" than it is. No amount of
financial acrobatics will ever yield consistently accurate projections and no
model will ever produce a perpetual streak of world-beating returns. So despite
the seemingly infallible analysis, the only way to make big money in the market
is to make a qualified bet and pray for divine intervention. Make no bones about
it fellow reader, for you are playing with chance. If you still harbour
illusions about taming randomness then we pray that the odds forever side with
you. But if there's one thing that's certain in life, it's that lady luck owes
no allegiance for she dances on the annals of victory and broken dreams with
equal fervour.

Disclaimer: No content on this website should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. The author accepts no liability for any actual investments based on this article.